MLP Basics: A Simple Way to Understand Master Limited Partnerships

Everything about master limited partnerships seems a little different than typical companies, and this can make digging into these businesses a tricky endeavor. However, during my conversation with Roger Young a few weeks ago, theenergy business veteranbroke it down in a way anyone could understand: "The best analogy I use," he said, "is to compare it to the Golden Gate Bridge."

Young has over 40 year of experience in the energy sector, and is now managing energy and MLP-focused equity portfolios for Miller/Howard Investments. He explained that master limited partnerships can offer stable cash flows, as well as reliable and growing distributions -- the MLP version of dividends. This, Young noted, is because of their Golden Gate-like qualities. Here are three reasons why the two are so similar.

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1. They provide an essential function Young focuses on "midstream" MLPs. One example he gave wasEnterprise Products Partners (NYSE: EPD).

Similar to other midstream MLPs, Enterprise Products manages and owns assets involved in the transportation (pipelines), processing, and storing of natural gas, crude oil, and refined petroleum products. These operations provide the link between "upstream" exploration and extraction and the "downstream" refining, selling, and distribution.

As Young noted, the Golden Gate Bridge is the "the quickest way to get from San Francisco to Sausalito." In the same way, Enterprise Products' 51,000 milesof pipelines provides an efficient way to transport oil and natural gas.

The U.S. consumed about 19 million barrels of petroleum products per day in 2014, according to the U.S. Energy Information Administration.This material puts gas in your car and fuels trucks and airplanes, among many other uses. For this to remain a reality, the companies that provide the bridge from upstream to downstream are essential.

2. Toll-road business model Although they provide essential functions, one major concern about energy companies is their history of booms and busts. Returning to the analogy, in crossing the Golden Gate Bridge, Young said, "Your toll is based on the number of wheels on your vehicle, it is not based on the value of your vehicle." He added: "In most cases, an MLP doesn't particularly care whether oil is $120 or $40 a barrel. If they are moving it, they are getting a fee for it."

Essentially, MLPs attempt to insulate themselves from swings in commodity prices by using fee-based operations. For instance, Enterprise Products generates approximately 85% of its gross operating margin from long-term and fees-based contracts -- gross operating margin is similar to EBITDA, which is used to give a better idea of the operating performance of the company by stripping out expenses not directly related to operations.

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There are, of course, arguments to be made for indirect exposure to commodity prices. For instance, falling or reduced oil prices could slow production, which could generate less volume for MLPs to manage. However, you could also argue that lower gas prices might generate greater demand at the pump and thus more potential demand for MLPs. Either way, as long as there is equal parts supply and demand, there will be a need for transporting, processing, and storage.

3. They are geographically monopolistic When a business is essential, or in high demand, it often breeds heavily competition. As Warren Buffett has said, investors should look for businesses with a wide moat, or competitive advantage, that keeps rivals from storming the castle and stealing profits.

Young said, like the Golden Gate Bridge, master limited partnerships are "geographically monopolistic," meaning no two MLPs have the same geographic footprint. Most important, having an established network of pipelines creates organic growth opportunities -- the ability to extend existing pipelines, or build new lines through already-secured land. Not every company will have large and interconnected system of pipelines, but those that do have a significant competitive advantage.

Moreover, "What happens to tolls? They go in one direction, up!" Young said. "And why can that happen? It's called being geographically monopolistic." In fact, it is because of these monopolistic qualities that some pipeline fees are even regulated by the Federal Energy Regulatory Commission, FERC. This means that an interstate pipeline owner cannot raise their fees solely at their discretion if that pipeline serves what FERC defines as a non-competitive region. Instead, increases in rates are often based on indexes such as the Producer Price Index. The benefit, however, is that this system adds a layer of protection against inflation, and helps MLP's returns keep up with rising costs over time.

The combination of these reasons, as well as focusing on fee-based sources of revenue, has allowed Enterprise Products to increase its distribution to shareholders for 43 consecutive quarters. This has happened despite dramatic swings in commodity prices over the last decade.

Should you consider MLPs? Becoming familiar with a new industry, or investment class, is never easy. But with many of these companies producing stable and predictable cash flow -- Enterprise Products Partners being one of them -- and industry yields averaging near an eye-popping 6%, they could be well worth the time and effort.